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When Investing in Hedge Funds, Don’t Aim For Home Runs

When Investing in Hedge Funds, Don’t Aim For Home Runs

When selecting hedge funds for your clients, don’t look for home runs, said Mark Willoughby, principle and wealth manager of Modera Wealth Management, during an fi360 webinar this week. Hedge funds and other alternative strategies can provide a reasonable rate of return and lower or negative correlations to stocks and bonds, but they can also carry greater risk.

“When we’re looking to add hedge fund exposure to our client portfolios, we’re looking for singles and doubles,” Willoughby said. “We’re looking for trading strategies that have a low-level of correlation to the traditional stock and bond market but if you look at them on their own, have a relatively low volatility for that hedge fund trading strategy itself.”

Willoughby, whose firm has been using alternatives for 20 years, said that as a fiduciary, you should at least consider the use of alternatives even if you use passive allocation, especially because correlations between traditional asset classes are increasing. Average five-year correlations between traditional stocks and bonds have increased from 0.5 for the period from August 1996 to July 2001 to 0.72 for the period from August 2006 to July 2011, he added.

The key is to choose hedge funds strategies that are less correlated to each other, as well, Willoughby said. During his presentation, Willoughby showed two “Heat Maps,” one showing the high correlations between traditional equity/debt indices, and another showing lower correlations between different hedge fund strategies. Managed futures is one alternative strategy that some say provides a low correlation to traditional asset classes.

“You can put together a hedge fund portfolio that, within itself, is extremely non-correlated,” Willoughby said. “So not only are we looking for hedge funds that are uncorrelated to traditional markets, within the hedge fund portfolio itself, we’re looking for hedge funds that have different sources of risk and return to each other.”

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Many institutional investors allocate as much as 50 percent to alternative investments, said Tom Orecchio, principle and wealth manager of Modera, during the webinar. But these investors have longer time horizons; a more appropriate allocation for individual investors would be 5 to 25 percent, depending on the client’s risk tolerance.

Guy Barudin, managing director of asset management firm Terrapin Partners, emphasized the value that alternative strategies can bring in volatile markets, such as the one we’re experiencing now. “You can pretty much buy a mediocre mutual fund or ETF in good markets,” he said. “It’s real value when it’s created in the current kind of volatile or sideways market. Our experience is that there are a range of private fund strategies that do consistently and reliably deliver alpha if they’re carefully selected, [put through due] diligence and monitored.

“And it should be non-correlated,” Barudin added. “Why should it be non-correlated? Because the return from the investments generally come from sales, operating improvements, cash flow, and sales to strategic buyers, which are generally not dependent on the public market.”

That said, there can be risks and downsides to investing in private alternative strategies, such as illiquidity, less transparency, more complicated tax structures, and higher fees. “Part of the trade-off there for your clients is, will the compensation reward them for that lack of liquidity?” Barudin said. “For the properly selected investment, it should.”

This is where investment manager research comes in. With private investments, understanding the operations behind the investment and the firm is extremely important, Barudin said.

“The values of these firms, as they trade from private owner to private owner have more to do with operations and internal execution and relatively little to do with the public markets,” Barudin said. “The risks are more associated with selecting the right managers and the right industries and sectors to invest as opposed to the markets in general.”

Barudin recommends conducting a background check and personal research on the key managers of the underlying assets. If they can’t provide complete transparency, he won’t invest. “The point is to remove any possible risk of being dealt with by folks who aren’t doing exactly what they say they going to do.”

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